Tuesday, October 7, 2008

How Low Can We Go?

That's the $64,000 question, or more appropriately, the $1 trillion+ question. Judging from the charts, it looks like there's a lot more downside to this market, as I've been saying for a while. Stock prices are going into freefall and where they land is anybody's guess. The market environment is of galactically ugly proportions. Consider the following:

The VIX continues to rise to levels we've never seen before (the VIX was recalibrated in 2003).

The buy/sell ratio is at lifetime lows of around 0.05. This is in part due to the next fact.

Forced hedge fund and mutual fund redemptions is adding pressure to the market's downward momentum.

The Arms Index (aka the Trin) has been running at extremely high levels. Historically, a high Trin was a leading indicator of a market reversal—but this hasn't happened yet.

The Tick has been trading mostly below zero, sometimes hitting below -2500. The Tick reflects the high negative VWAP values we've been experiencing. Extremely negative VWAP values are also a sign of heavy institutional selling.

If you've been invested in energy or materials stocks, you've gotten your butt kicked. But you don't need me to tell you that. Virtually the only winners in the past few weeks have been the short and ultra-short ETFs. As I've been saying, I don't know how much longer we can rely on them to perform. Some of the gains are really getting out of hand, but yet, I believe some of them are poised to move much higher, like the SKF (discussed below).
Chartology: the Dow Transport message
Let's see if we can make some sense of the weekly chart of the Dow Transports.

The next support level is around 380 followed by 340 and 290. I firmly believe that we'll be seeing the 380 mark (or very close to it), the reason being that it's roughly the same 90 point difference between the top of the double top formation to the neckline (540 – 450) as it is from the neckline (at 450) to that support level. (See chart.) At the end of the previous bear market in 2003, the Transports hit a low of 200. That's about 50% from here and I'm hoping we won't see it reach that point again. On a cheerier note (relatively speaking), both the S&P 500 and the Dow Industrials only have to drop another 17% or so to reach their 2003 lows.

Another fly in the ointment
The ban on naked short selling is being lifted tomorrow so we can expect to see more stocks take a hammering especially the financials, the previous darlings of naked short sellers. This will only send the market lower.

Isn't there any good news?
Maybe. Earnings season kicks off today and if across the board results aren't as nasty as some predict, they could provide a shot in the arm to this ailing market. Also, the Fed is meeting in a few weeks to discuss interest rates, but I think the effect of that decision is going to be secondary.

Until we get that final spike in the VIX signaling a market turnaround, staying on the sidelines ain't a bad place to be. But if you have to be in the market, buying the ultra-short financials ETF, the SKF, wouldn't be a bad short-term play. For you options gamblers, the April 135 call is attractively priced at about 80% of its Black-Scholes value and has decent open interest (1659). If you do elect to buy some options, be prepared to get out fast as this trade could quickly turn against you.

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